Using Enterprise Value to Measure a Company’s Worth

What Is Enterprise Value?

Enterprise value (EV) is a measure of the total value of a business. In other words, it reveals how much a company is worth.

We can think of it at a company’s takeover price or takeover valuation: it’s a calculation that represents the entire cost of a company if another entity were to buy it. It accounts not just for the total value of the company’s shares of stock — this is known as market capitalization, or market cap — but also for that company’s debt and cash. 

EV is a more comprehensive alternative to other similar measures, and is often used to value a company for a potential takeover.

Enterprise value essentially represents a business’ balance sheet: it accounts for all of its current stock, debt, and cash.

What Is EV Used For?

1. EV may be used during acquisition

When looking to acquire a company, a purchaser needs to consider not just that company’s market value but also that company’s debt and other assets. Upon acquisition, the acquirer takes on the acquired company’s debt — which would increase the overall cost of buying the company — as well as the company’s cash — which reduces the cost.

2. EV may be used for comparing companies

The enterprise value of a company is a useful metric for comparing its value to the value of other companies, especially those with different capital structures — capital structure is how a company uses debt and equity to finance itself.

The Formula and its Components

The EV formula

Enterprise Value = Market Capitalization   +   Preferred Stock   + Debt – Cash

The formula is the sum of a company’s market equity value and market value of debt, minus any cash or cash equivalents.

Breaking down each component

Market Capitalization

Also known as market cap, this is the number of outstanding shares (or shares of common stock that have been issued to the public) a company has multiplied by its stock price. Market cap isn’t intended to represent a company’s book value (the net value of a company’s assets), just its market value.

For example, if a company has 1 million shares of common stock and its current share price is $70 per share, then that company’s market cap would be $70 million. 1 million shares x $70 per share = $70 million market cap.

Also known as market cap, this is the number of outstanding shares (or shares of common stock that have been issued to the public) a company has multiplied by its stock price. Market cap isn’t intended to represent a company’s book value (the net value of a company’s assets), just its market value. For example, if a company has 1 million shares of common stock and its current share price is $70 per share, then that company’s market cap would be $70 million. 1 million shares x $70 per share = $70 million market cap.

Preferred Stock

Like common stock, preferred stock also represents a piece of ownership in a company, but preferred stock has some differences. Preferred stock gives no voting rights to shareholders, while common stock does. Preferred shareholders receive priority when it comes to company assets — they are paid dividends before common shareholders are. A preferred stock issue essentially behaves like debt in that it needs to be repaid, and otherwise represents a claim on the business that needs to be factored into the calculation of enterprise value.

Like common stock, preferred stock also represents a piece of ownership in a company, but preferred stock has some differences. Preferred stock gives no voting rights to shareholders, while common stock does. Preferred shareholders receive priority when it comes to company assets — they are paid dividends before common shareholders are. A preferred stock issue essentially behaves like debt in that it needs to be repaid, and otherwise represents a claim on the business that needs to be factored into the calculation of enterprise value.

Debt

When someone acquires a company, they also acquire that company’s short-term and long-term debt.

For example, if you acquire a company with a market cap of $20 million that also has $10 million in total debt, the real cost of the acquisition is $30 million: you’d be paying $20 million, but are now also responsible for repaying the amount of outstanding debt that your new company owes, which in this case is $10 million.

When someone acquires a company, they also acquire that company’s short-term and long-term debt. For example, if you acquire a company with a market cap of $20 million that also has $10 million in total debt, the real cost of the acquisition is $30 million: you’d be paying $20 million, but are now also responsible for repaying the amount of outstanding debt that your new company owes, which in this case is $10 million.

Cash (or cash equivalents)

Cash refers to the liquid assets of a company — these could include short-term investments, marketable securities, and money market funds. Similar to debt, when someone acquires a company they also acquire all of that company’s cash.

Cash is subtracted from the enterprise value because it will reduce the costs of acquiring the target company. It’s assumed that the acquirer will use the cash to pay off a portion of the takeover price — it would be used to pay a dividend or to pay off debt.

For example, if you acquire a company that’s valued at $80 million in market capitalization that has $10 million in cash, you would immediately gain access to that $10 million upon purchase. Thus, your “real” cost would only be $70 million.

Cash refers to the liquid assets of a company — these could include short-term investments, marketable securities, and money market funds. Similar to debt, when someone acquires a company they also acquire all of that company’s cash. Cash is subtracted from the enterprise value because it will reduce the costs of acquiring the target company. It’s assumed that the acquirer will use the cash to pay off a portion of the takeover price — it would be used to pay a dividend or to pay off debt. For example, if you acquire a company that’s valued at $80 million in market capitalization that has $10 million in cash, you would immediately gain access to that $10 million upon purchase. Thus, your “real” cost would only be $70 million.

When and Why Is It Used?

In addition to being used as a takeover   valuation   metric , enterprise value is also used as the   basis for many other financial ratios and multiples that measure the performance of a company , including EV/EBITDA, EV/EBIT, EV/FCF, and EV/Sales.

• EBITDA: this measures a company’s ability to generate revenue, used as an alternative to only earnings or net income. It’s calculated like this: EBITDA = recurring earnings from continuing operations + interest + taxes + depreciation + amortization
• EV/EBITDA: this compares the value of a company (including debt) to its cash earnings minus expenses. It’s often used by financial analysts and investors to compare companies within the same industry. 
• P/E ratio: Enterprise value is often used in tandem with the P/E ratio in valuations. Similar to enterprise value, the P/E Ratio (also known as the price-to-earnings ratio) is a ratio for valuing a company. This ratio measures a company’s share price relative to its per-share earnings. Unlike EV, however, the P/E ratio doesn’t take a company’s net debt into consideration. 

Limitations

While enterprise value does provide a more comprehensive valuation than some other measures do, it does present some limitations as well. 

The amount of debt largely depends on the industry, and so it’s often best to compare companies to their peers within the same industry.

One factor that sets enterprise value apart from other metrics is that the measure includes net debt. However, it’s also important to take into consideration how that debt is being utilized by the company’s management: a greater amount of debt isn’t necessarily a bad thing, and it can sometimes be used to foster growth.